What’s so smart about smart beta ETFs?

Remember when index funds and ETFs simply tracked the broad stock and bond markets? Many funds still do, of course, but a bunch of new kids have moved into the neighbourhood. They call themselves “smart beta ETFs” and you’re likely to see more of them in the coming year.

So what is smart beta, anyway? In the jargon of the financial industry, beta describes the risk and return of the overall market—which is what you’d get in a traditional Couch Potato portfolio. “Smart beta” is an attempt to build alternative indexes designed to outperform the market.

The best way to explain it is with an example. Consider the iShares Core S&P/TSX Capped Composite Index ETF (XIC), which holds about 250 Canadian stocks. Each is weighted according to size: huge companies such as Royal Bank, CN Rail and Suncor make up between 3% and 6% of the fund, while smaller companies like Canadian Tire and Air Canada make up a fraction of a percent. This index fund is pure beta, and it carries a management fee of just 0.05%.

Now look at the First Asset Morningstar Canada Value Index ETF (FXM), an example of a smart beta ETF. Its index looks for companies that appear underpriced according to measures such as price-to-earnings ratio, price-to-book value and estimated earnings. The 30 stocks that best meet these criteria are given an equal share of the index (about 3.3% each). By zeroing in on these value stocks, the ETF hopes to outperform traditional index funds.

Fine, you ask, but what makes this different from any other active fund designed to beat the market? With smart beta ETFs there is no human manager making the decisions. Tracking an index protects you from overconfident fund managers who make big bets on individual stocks or hoard cash so they can time the markets. It’s also much cheaper, because indexes don’t wear bespoke suits and drive BMWs. Management fees on smart beta ETFs are typically between 0.50% and 0.80%.

ETFs tracking alternative indexes have been around for about a decade, but in the last couple of years smart beta is popping up everywhere, promising to deliver higher returns or lower risk. So, should you abandon your Couch Potato portfolio for one that’s “smarter”?

It’s unfair to dismiss smart beta as a marketing gimmick. Many strategies used by these ETFs are based on research that is decades old. Value stocks, small-cap companies, stocks with momentum—all of these have indeed been shown to outperform the broad market over the long term in many studies. (Disclosure: The investment firm I work for uses smart beta funds from Dimensional Fund Advisors with many clients.) But any time you stray from a traditional index approach, you open yourself up to potential problems. So before you jump on the bandwagon, consider the following.

You might be taking more risk. Some smart beta ETFs include a relatively small number of stocks, and these may be concentrated in just a few sectors. That might not offer the diversification you would get from a portfolio of ETFs tracking hundreds or thousands of stocks. And while you might enjoy a higher return from value stocks or small-cap stocks, it could come at the cost of more volatility.

Extra cost can outweigh the benefits. Plain-vanilla index funds have almost negligible costs these days: 0.05% is not unusual, and that’s just $5 on every $10,000 invested. Smart beta funds may be cheaper than active mutual funds, but they can still be half to three-quarters of a percentage point more expensive than traditional ETFs. Even if they outperform before costs, that higher fee could wipe out any advantage.

They may be less tax-efficient. Traditional index funds have very little turnover, since it’s relatively rare for stocks to be added or deleted from the index. By contrast, smart beta funds with a lot of rules may see a greater number of companies moving in and out of the indexes, which can translate into more buying and selling, and more taxable capital gains for investors.

Outperformance is fleeting. While value and small-cap stocks have outperformed over the very long term, there will always be periods when they lag the market. Sometimes the underperformance can be big, and it can last a long time. The last few years have been very difficult for Canadian small-cap and value stocks, for example. If you’re going to use smart beta ETFs, you need to have conviction in the strategy and hang on through those inevitable rough periods: otherwise you’ll never reap the potential rewards.

Successful investing is built on a foundation of diversification, low cost and long-term discipline. Traditional index funds are not perfect, but they are the best way to build a cheap, tax-efficient, global portfolio that is easy to understand and manage. Smart beta is fine in theory, but unless you pay attention to the pitfalls you could end up being the dumb money.